Listening to Greenspan

WASHINGTON (CBS.MW) -- Alan Greenspan takes center stage in the coming week, as the world tries to guess what the Federal Reserve will do at its next meeting on Jan. 30-31.

The Fed chairman will speak on "evolving fiscal challenges" in testimony at the Senate Budget Committee on Thursday at 10 a.m. Eastern. "Evolving fiscal challenges" is code for "Will Greenspan endorse the Republicans' tax cut ideas?" See our calendar of Washington events.

The senators will also want to know if a tax cut would make the Fed's job of stabilizing the economy with rate cuts easier or harder.

Financial markets have priced in an aggressive 50-basis point rate cut in the Federal funds target rate on Jan. 31, but that's certainly not set in concrete. The Fed lowered the Federal funds rate by a half percentage point in an abrupt move on Jan. 3.

Fed policymakers will scrutinize the economic data for guidance about what to do next. If the economy seems to sinking into a major downturn, then the Fed will be compelled to slash interest rates rapidly.

But if the weak economic data are more transitory or if inflationary pressures heat up again, then the Fed will be more cautious, much more cautious than the suddenly optimistic markets want.

Market participants will have to watch the same data as the Fed, plus try to figure out what the Fed is thinking.

That's where Greenspan could come in. He doesn't like to talk in specifics about what the Fed is going to do, but the hearing is sure to raise plenty of questions about how much stimulus the economy can expect from the Fed. The new Bush administration is pushing for a big tax cut, in part, to stimulate aggregate demand. Read more.

Fiscal and monetary policies work on the economy with different lags. Fiscal policy (taxes and government spending) works fast, but the decision making process can take months. Monetary policy, on the other hand, can be changed with just one phone call from Greenspan, but it can take a year or more to fully hit the economy.

Washington has come to rely exclusively on monetary policy to manage the economy, largely because it's proven to be almost impossible politically to reverse fiscal stimulus once it's approved.

In past testimony, Greenspan has always given the same answer when asked about tax cuts: He favors using the growing federal surplus to pay down the national debt. But if that's not possible, he would favor a broad tax cut to new spending programs.

One Fed watcher expects the Fed chairman to make a deal with the White House. "You'll see Greenspan compromising on tax cuts if he gets an agreement on debt reduction," said Diane Swonk, chief economist at Bank One.

Swonk thinks the Fed will ease again, but not aggressively. She's counting on the economy to perk back up by mid-year. By next year, she expects the Fed to be battling the stimulative effects of a tax cut with higher interest rates.

The highlight will likely come on Thursday with the release of fourth-quarter employment costs. The ECI rose 0.9 percent in the third quarter, but economists we surveyed think it'll bounce up to a 1.1 percent gain, bringing the yearly gain to 4.5 percent.

The ECI is the best overall gauge of inflation in the labor market, which had been the Fed's major concern from May 1999 to June 2000.

"A stronger-than-expected ECI would make the Fed more cautious," said Cary Leahey, economist at Deutsche Bank. That would mean expectations for a 50-basis point ease could evaporate. Leahey doesn't think the ECI would stop the Fed from a 25-basis point cut, however.

So far, productivity gains have far outstripped the increase in employment costs, which means unit labor costs have not added to price pressures for companies.

The leading indicators are expected to fall again (by 0.3 percent), but that's not a surprise, given the LEI's heavy reliance on manufacturing data. The Conference Board also says it's changing the way the index is put together and warns that month-to-month changes won't be comparable to its previous data.

Durable goods orders are expected to slump by 0.9 percent after jumping 2.5 percent in November. The durables report is volatile and hard to forecast.

Rex
Nutting

Rex Nutting is a columnist and MarketWatch's international commentary editor, based in Washington. Follow him on Twitter @RexNutting.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.